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International Tax Compliance Alert

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26 Jul 2011

The Internal Revenue Service (the IRS) issued Notice 2011-53 (the Notice) announcing plans to phase in the requirements of the Foreign Account Tax Compliance Act (FATCA), which enters into force January 1, 2013.1

SUMMARY OF PHASE-IN DATES

Activity

Date

Withholding on:

US FDAP income payments

Gross proceeds

Pass-thru Payments

January 1, 2014

January 1, 2015

January 1, 2015

Entering into FFI Agreement

By June 30, 2013 to avoid FATCA withholding commencing January 1, 2014.

US account ID procedures for pre-existing (including high-risk accounts) and new US accounts

Will begin in 2013, as summarized below.

Reporting of US accounts

Earliest date, September 30, 2014, as summarized below.

Time for future published guidance:

Proposed Regulations

Final Regulations

Draft, followed by final versions of, FFI Agreements and reporting forms

By December 31, 2011

By summer 2012

By summer 2012

WHY NOTICE WAS ISSUED

In response to numerous comments concerning the practical difficulties in implementing FATCA by January 1, 2013, the Notice provides a phase-in for the implementation of FATCA. Commentators had requested transitional relief because of the lack of definitive guidance and the significant lead-time (18 to 24 months) that FFIs require to revise their IT systems once final guidance is issued. The Notice also acknowledges the reality that the effective implementation of FATCA will require coordination with foreign governments to resolve (if possible) the potential conflicts between FATCA and foreign laws. FATCA is a US-centric law that imposes expansive extraterritorial obligations, particularly on FFIs. A number of these US obligations may conflict with local law prohibitions with respect to privacy, data protection, anti-discrimination and withholding “foreign” taxes, generally if the account holder or member does not otherwise consent, thereby exposing FFIs to potential regulatory sanctions, civil lawsuits and possible criminal exposure in their local jurisdiction.

PHASE-IN IMPLEMENTATION TIME LINE

Background. Under FATCA, effective for payments after December 31, 2012 (subject to a limited transitional rule), Withholdable Payments (defined below) are subject to a new 30 percent US withholding tax (the FATCA Withholding Tax) unless a foreign financial institution (FFI) enters into an agreement with the US Internal Revenue Service (FFI Agreement) under which the FFI must, among other undertakings, determine whether it has US account holders, comply with IRS verification and due diligence procedures with respect to the identification of US accounts, annually report US account information to the IRS, and withhold FATCA Withholding Tax on so-called “pass-thru” payments. An FFI that enters into an FFI Agreement is referred to as a “Participating FFI” and an FFI that is not compliant with FATCA is referred to as a “Non-Participating FFI.” A Non-Participating FFI and a “Recalcitrant Account Holder” (i.e., an account holder that fails (i) to comply with reasonable requests for information pursuant to IRS mandated verification and due diligence procedures to identify whether an account is a US account; (ii) to provide a name, address and taxpayer identification number in the case of a direct or indirect US account holder; or (iii) to provide a bank secrecy waiver upon request) are subject to the pass-thru payment rule. A similar but less burdensome rule applies to payments to foreign entities other than FFIs (“NFFEs”). NFFEs are subject to the FATCA Withholding Tax unless the NFFE (or beneficial owner) provides the Withholding Agent with either (i) a certification that the NFFE does not have substantial (more than 10 percent) US owners that are subject to reporting under FATCA or (ii) certain information with respect to its substantial US owners.

Withholding

A Withholdable Payment is comprised of two categories:

US FDAP Income Payment.Interest (including original issue discount) dividends, rents, salaries, wages, premium annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits and income, if such payment is from sources within the United States.

Gross Proceeds Payment. Any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from US sources (e.g., from the sale of disposition of US stocks or securities).

A Withholding Agent is any person, whether US or foreign, having the control, receipt, custody, disposal, or payment of any Withholdable Payment. A Withholding Agent may include a Participating FFI.

Withholding Phase-In

Withholdable Payments

The Notice provides two phase-in dates:

1. For payments on or after January 1, 2014, Withholding Agents will be obligated to withhold only on US FDAP Income Payments.

2. For payments made on or after January 1, 2015, Withholding Agents will be obligated to withhold on all Withholdable Payments.

Comments

The transitional rule for Gross Proceed Payments should be particularly helpful to Withholding Agents because, by delaying withholding for these payments, Withholding Agents can continue to use their existing withholding systems (for US FDAP Income Payments) for an additional year while they implement systems for the more expansive FATCA Withholding Tax.

Note the interaction between the Withholdable Payment rule and the Pass-thru Payment rule (discussed below), particularly because any person is a Withholding Agent for a Withholdable Payment. Examples illustrating this interaction are provided in the comment section of the transitional Pass-thru payment rule below

Pass-thru Payments

A Pass-thru Payment means any Withholdable Payment or “other” payment to the extent attributable to a Withholdable Payment. The Pass-thru Payment rule does not apply to NFFEs.

The Notice provides that, for payments made on or after January 1, 2015, a Participating FFI must withhold the FATCA withholding tax on Pass-thru Payments, particularly “other” Passthru Payments.

The Notice provides that the obligations of a Participating FFI with respect to computing and publishing its passthru payment percentage (PPP) 2 will not begin before the first calendar quarter of 2014.

The Notice provides that the grandfather rule for obligations in existence on March 18, 2012, will apply to Pass-thru Payments in existence on that date (unless the obligation is treated as equity for US tax purposes, or lacks a definite expiration or term).

Comments

Participating FFIs will be obligated to withhold on US FDAP Income Payments made on or after January 1, 2014 but will not be required to withhold with respect to “other” Pass-thru Payments made before January 1, 2015.

In application, the different phase-in dates applicable to Withholdable Payments and Pass-thru Payments create different effective dates for withholding. For example, assume a Participating FFI holds stock of a US corporation in a custodial account for a Recalcitrant Account Holder and receives a dividend in 2014 from a US corporation. The FFI must treat the dividend, US FDAP Income, as a Withholdable Payment when credited to the account of the Recalcitrant Account Holder and withhold the FATCA Withholding Tax, even though the Notice provides that the Pass-thru Payment rule only applies to pass-thru payments in 2015. Effectively, in this case, the transitional Withholdable Payment rule only applies and not the transitional Pass-thru Payment rule.

Contrast the foregoing example with an example in which a Participating FFI holds the stock of a US corporation for its own account and receives a dividend from the US corporation in 2014 and makes a payment to a Recalcitrant Account Holder in 2015. In this case, the payment to the Recalcitrant Account Holder would not be a US FDAP Payment, since the payor is a foreign corporation. The dividend would be foreign source and would constitute an “other” payment for Pass-thru Payment purposes. Thus, under the transitional rule for Pass-thru Payments, there would be no FATCA Withholding Tax imposed in 2014 but there would be a FATCA withholding tax imposed in 2015, based on the PPP of the Participating FFI that is making the payment to the Recalcitrant Account Holder.

In view of the phase-in dates for computation of the PPP, FFIs need to be carful as to how they compute their PPP. FFIs may want to consider using the alternative transition method specified in Notice 2011-34 for computing the PPP for 2014.2

Registration of FFIs phase-in

The Notice provides that the IRS will begin accepting applications to enter into FFI Agreements no later than January 1, 2013. For FFIs that enter into an FFI Agreement before June 30, 2013, the IRS will treat those FFIs as Participating FFIs, effective on July 1, 2013. Thus, the Withholding Agents will not be required to withhold on these FFIs when the FATCA Withholding Tax takes effect on January 1, 2014.

FFIs that enter into FFI Agreements after June 30, 2013, but before January 1, 2014, will be Participating FFIs for 2014 but might not be identified as such in time to prevent withholding beginning on January 1, 2014 because of the time needed to process FFI applications and for US Withholding Agents to verify whether a payee is a Participating FFI.

Effective date of FFI agreement

The effective date of an FFI Agreement entered into any time before July 1, 2013 will be July 1, 2013.

The effective date of an FFI Agreement entered into after June 30, 2013, will be the date the FFI enters into the FFI Agreement.

Comment. The effective date of an FFI Agreement is an important date and must be kept in mind for various FATCA implementation purposes, including for the application of the alternative transition method rules relating to FFI due diligence and the determination of the PPP, as discussed above.

Participating FFI due diligence

New accounts

A Participating FFI must put in place account opening procedures to identify US accounts that are opened after the effective date of an FFI Agreement (as described in Notice 2010-60). These procedures must be in place on or after the effective date of the FFI Agreement.

Comment. The Notice requires a Participating FFI to have in place the new account opening procedures, as described above, on or after the effective date of the FFI Agreement. Thus, if an FFI decides to enter into an FFI Agreement effective July 1, 2013, it will be necessary that it commence development and implementation of its IT systems prior to the effective date of the FFI Agreement. The IRS’s proposed timeline for finalizing Treasury Regulations may not give the FFI much time to develop IT systems.

Pre-existing private banking accounts equal to or greater than $500,000

A Participating FFI must put in place account opening procedures (as described in Notice 2011-34) on all Private Banking Accounts opened before the effective date of the FFI Agreement and that have a balance or value of at least $500,000 on the effective date of the FFI Agreement. The Participating FFI must perform a diligent review of paper and electronic files for each such account to determine whether the account reflects indicia of US ownership and follows protocols to make determinations of US status within one year of the effective date of the FFI Agreement.

Comment. The Notice, through use of a parenthetical, states that the private banking identification procedures will also apply to entity accounts, which is an expansion on the scope of the private banking procedures contained in Notice 2011-34.

Pre-existing private banking accounts less than $500,000

A Participating FFI must put in place account opening procedures (as described in Notice 2011-34) on all Private Banking Accounts opened before the effective date of the FFI Agreement and that have a balance or value less than $500,000 on the effective date of the FFI Agreement. The Participating FFI must perform a diligent review of paper and electronic files for each such account to determine whether the account reflects indicia of US ownership and follow protocols to make determinations of US status by the later of (i) December 31, 2014, or (ii) the date that is one year after the effective date of its FFI Agreement.

Comment. The Notice lengthens the Notice 2011-34 (Step 3) one-year time period for performing the private banking account due diligence protocols for private banking accounts with less than $500,000, compared to those for $500,000 or more, which due diligence inquiry must be performed within a one year time period.

Due diligence requirements for other pre-existing accounts

The Notice provides that, for all accounts other than Private Banking Accounts, the Participating FFI must complete the due diligence procedures specified in Notice 2011-34 (requiring the FFI to determine whether an account reflects indicia of US ownership and procedures for determining US status) within two years of the effective date of the FFI Agreement.

Additional due diligence guidance

The Notice states that forthcoming regulations will provide further guidance on the scope of the private banking procedures and the associated search of account holder files, as follows:

Forthcoming regulations will also provide that, for purposes of the private banking account review procedures set forth in Notice 2011-34, the diligent review of the account files may be completed by any person designated by the Participating FFI.

Comment.The Notice permits any person designated by the Participating FFI (no longer limited to the account relationship manager) to perform the diligent review.

Accounts subject to due diligence procedures and identified as either US accounts or non-US accounts will not be subject to additional due diligence procedures in subsequent years unless the account undergoes a change of circumstances.

Reporting account information

New accounts, documented US accounts and private banking accounts

The Notice provides that an account for which a participating FFI has received a Form W-9 from the account holder (or, with respect to an account held by a US-owned foreign entity, from a substantial US owner of such entity) by June 30, 2014, must be reported to the IRS as a US account by September 30, 2014.

Where an FFI is not able to report the information above for a US account by June 30, 2014, the FFI will be required to identify such account to the IRS as a Recalcitrant Account Holder by September 30, 2014.

Comments

The Notice provides greater flexibility for FFIs to satisfy the reporting requirements specified in Notice 2011-34 in 2014, but is not intended to change the information that generally must be reported in Notice 2011-34.

The Notice provides that the IRS will assess the accuracy of the information reported by the FFI and communicate with the FFI to resolve discrepancies in the information received. Unresolved discrepancies could result in an account being treated as held by a Recalcitrant Account Holder.

Significantly, the Notice provides that for each account for which the Participating FFI is not able to report information because, for example, the account holder has not waived any applicable local law reporting restrictions, the FFI will report the account among its Recalcitrant Account Holders with US indicia in accordance with Section IV.F. of Notice 2010-60, which requires a Participating FFI to report the number and aggregate value of financial accounts held by Recalcitrant Account Holders that have US indicia. This means of reporting ostensibly may not violate local law restrictions on data protection or bank secrecy because the report does not disclose individual names or data, but is reported on an aggregate basis.

Reporting with respect to Post-2013 Years

Reporting with respect to 2014 and subsequent years will be required as contemplated in Notice 2010-60 and Notice 2011-34 and as implemented in future regulations.

Timeline for future guidance

The Notice announced that the IRS anticipates issuing proposed Treasury Regulations incorporating the contents of the Notice, Notice 2010-60 and Notice 2011-34 by December 31, 2011 and final Treasury Regulations in the summer of 2012. The Notice further announced that the IRS anticipates issuing draft versions (followed by final versions) of the FFI Agreement and reporting forms to be used by Withholding Agents and participating FFIs in the summer of 2012.

GENERAL COMMENTS

In announcing the transitional rules, the IRS Commissioner stated that “… the IRS recognizes that implementing FATCA is a major undertaking for financial institutions” and “[Notice 2011-53] is a reflection of our serious commitment to implementation of the statute, but also a serious commitment to listen to the implementation challenges of affected financial institutions and make appropriate adjustments to ensure a smooth and timely roll-out.”

The transitional rules represent a positive step in addressing the financial industry’s concerns about implementing FATCA by January 1, 2013, particularly because of the current lack of guidance on a number of issues and the significant lead time required to implement IT system enhancements or changes. Nonetheless, the timing of the phase-ins and the manner in which the Notice refers to the two earlier notices raise additional questions and concerns.

Timing. The promulgation of guidance implementing FATCA is a massive and complex undertaking. If the contemplated timeframes for finalizing the Treasury Regulations are delayed beyond the summer of 2012, the dates for phasing in FATCA information reporting and withholding will no longer comport with the projected completion of the project, thereby causing new concerns regarding the time period necessary to understand, evaluate and implement IT systems and protocols. As a number of commentators have suggested, it would have been preferable for the IRS to establish implementation timeframes by reference to dates after the final Treasury Regulations are published.

Content. The Notice states that the IRS anticipates proposing regulations incorporating the guidance contained in the notices, as modified and supplemented, and provide further guidance on other issues not previously considered. These statements (as well as other references in the Notice) may indicate that the IRS intends to incorporate the guidance contained in the notices in the regulations without significant modification to reflect recent taxpayer comments. Even if this were the case, stakeholders still would have to the opportunity to comment on the positions taken by the IRS in the proposed regulations.

As mentioned in the Notice, the IRS must still issue more guidance on a number of issues. Some of the important issues on which additional guidance should be issued include insurance/reinsurance companies and products, trusts and reclaims and refinement of guidance on such issues as deemed compliant status and retirement plans. Further, the Pass-thru payment provisions are contentious. Notice 2011-34 requested comments on potential exceptions to Pass-thru payments and other portions of the Pass-thru Payment provisions may be the subject of additional consideration. Finally, although beyond the scope of the regulations, it is not clear how or when conflicts between the local laws of foreign jurisdictions and FATCA will be resolved.

Thus, at this juncture, stakeholders should evaluate their particular situations by reference to the current guidance and await further developments.

Mr. Granwell would like to acknowledge the valuable input of Witold Jurewicz, an associate in DLA Piper’s Miami office, in the preparation of this article.

1 On July 25, 2011, the IRS announced that it has revised the Notice to clarify that the phase-in dates applicable to the FATCA Withholding Tax will apply to Withholdable Payments made to FFIs and NFFEs.

2 Notice 2011-34 provides that the PPP is determined by reference to the FFI’s total gross US assets and other assets, unreduced by liabilities, as of its quarterly testing dates, by dividing the sum of its US assets held on each of the last four quarterly dates by the sum of its total assets held on those dates. Notice 2011-34 provided an alternative transition method for computing the PPP.

3See Notice 2011-34, Section 5 (which provides that each participating FFI will be required within three months after its quarterly testing date to make available its PPP calculated for that testing date; otherwise, the Participating FFI’s PPP will be treated as 100 percent).

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